A Look At What Scares Investors Most

With the S&P 500 up 30% last year and another 6% this year, leaving it just 2% off its July record, some see a bubble. Even some mainstream advisers recommend caution.

“For investors concerned about short-term performance, I have been urging people to get a little more defensive and raise a little more cash to create a little more firepower for later,” said David Joy, chief market strategist at Ameriprise Financial Inc., which oversees $810 billion.

Some fear a bear market, meaning a pullback of 20% or more. Mr. Joy expects something smaller. Others say stocks already are past their troubles and it is time to buy.

A central question is whether market excess is as bad as before the collapses of 2000 and 2008. In 2000, speculative fever infected many large stocks. In 2008, excesses in housing and lending markets almost caused a depression.

The market looks different today. But fears remain, notably because unprecedented Federal Reserve intervention has distorted markets and stimulated borrowing in ways that are hard to evaluate.

Here is a look at some of the big issues on investors’ minds currently.

The Federal Reserve. Many believe this bull market’s main driver has been the central bank’s decision to hold interest rates at their lowest levels since World War II and to stimulate markets by buying more than $1 trillion in bonds.

Now, the Fed is ending the bond-buying and preparing to raise interest rates next year. The prospect of higher rates, Mr. Joy said, could unsettle markets. But he and many others add that investors should be able to shrug that off because the Fed intends to move slowly and keep rates low for years.

“I don’t see a big problem but rather a source of temporary uncertainty” with stocks falling 10% or so late this year, he said.

Adam Parker, Morgan Stanley’s chief U.S. stock strategist, said he thinks the pullback is already over. “I think this is a buying opportunity,” he said.

High Prices. “Our clients are concerned that the market has come so far in the past five years that stocks are expensive,” said Scott Wren, senior stock strategist at brokerage firm Wells Fargo Advisors in St. Louis.

The S&P 500 has nearly tripled since March 2009. It trades at 18.5 times its companies’ reported profits for the past 12 months, according to Birinyi Associates. The long-term average is 15.5.

Stocks clearly are expensive but not off the charts as in 2000, when the S&P 500 was near 40 times earnings. Stocks were about this expensive before 2008. But the big problem in 2008 wasn’t valuation; it was housing and lending.

Joseph Mezrich, head of quantitative investment strategy at Nomura Securities, measures the earnings gains needed to justify stock prices. Stocks now price in 7% earnings growth, which is normal, he said.

“The way I value the market,” he said, “there is no bubble at all.” The S&P could rise another 5% and it wouldn’t be overvalued, he said.

Earnings. “For our clients,” said Mr. Wren of Wells Fargo, “the number one concern is that the economy is going to slip into recession again.”

Corporate profits are rising at a single-digit percentage pace, down from big double-digit gains earlier in the recovery. Mr. Wren has been telling clients these gains are fine and sustainable, but they still hold more money in cash than he recommends, he said.

“Ultimately,” said Mr. Parker at Morgan Stanley, “the trajectory of earnings is what matters” for the future of stock prices and “I don’t know of anybody who thinks earnings are going down in the second half of the year.”

For stocks, only two aspects of geopolitics have mattered much in the past: energy prices and major U.S. troop involvement. With the latter unlikely, analysts are focusing on energy.

With oil supplies plentiful, attention centers on a possible Russian cutoff of natural gas to countries including Germany. A European recession would hurt U.S. corporate profits.

“Energy markets are a concern if there is any interruption in supply,” said Mr. Joy of Ameriprise, but he and others said it would take a big energy-price jump to hurt U.S. stocks much.

Speculation. Many worry that Fed cash injections and low interest rates have led to excessive investment with borrowed money.

Several market corners appear overheated, including biotech and social media companies, junk bonds, some real-estate investment trusts and securities backed by bank loans. Junk-bond prices sagged in July but have already begun recovering.

Investing with borrowed money using stocks as collateral, called margin debt, is at a record in dollar terms. But as a percentage of total stock-market value it isn’t near 2007 extremes, said independent market analyst Phil Roth.

However, investing today is dominated by hedge funds, which use other borrowing sources that are hard to track, Mr. Roth noted. Because no one knows how much they have borrowed, the uncertainty worries many people. If hedge funds have to raise cash because of declines in risky investments made with borrowed funds, no one knows how many mainstream stocks they might sell.

Many other potential problems are hard to gauge: the seriousness of China’s housing bubble, the strength of its financial system, the risk of global terrorism, the risk of another European financial blowup.

But by traditional measures, markets don’t look as excessive as in 2000 and 2008.